Are Institutional Investors Part of the Problem Or Part of the Solution?

Are Institutional Investors Part of the Problem or Part of the Solution? Key Descriptive and Prescriptive Questions About Shareholders’ Role in U.S. Public Equity Markets By Ben W. Heineman, Jr. and Stephen Davis Committee for Economic Development e Best of Business inking PREFACE Both the Millstein Center for Corporate Governance and Performance at the Yale School of Management and The Committee for Economic Development have had as a priority focus the essential governance principles of publicly held corporations. They have both asked fundamental questions about the optimal roles of business leaders, boards of directors, shareholders and other stakeholders in achieving long-term growth and innovation with sound risk management and high integrity. But both the Center and CED have become deeply concerned about the grow- ing role of institutional investors in our public equity markets, both as to how they serve the individuals who invest their money in these institutions, and in the relation- ship between the investors and investee companies. Even though institutional investors own more than seventy percent of the largest 1,000 companies in the United States, there is far less known about many of them than about the public companies in which they invest. There is great diversity in purpose, strategy, governance and incentives of institutional investors which range from pension funds to mutual funds to insurance companies to hedge funds to endowments of non-profit institutions. This important essay is an outgrowth of the lack of basic information concerning the role of institutional investors in our public equity world. In January 2011, the Center and CED, in conjunction with The Aspen Institute Business and Society Program, co-sponsored a research roundtable on institutional investors attended by academics, think-tank analysts, leading practitioners and former regulators. The purpose was to crystallize the need for research on these subjects. [See Appendix III for a list of attendees.] The research roundtable focused on three major questions: • Do institutional investors adequately advance the goals of the individuals who have invested in them? • Do institutional investors contribute significantly to “undesirable short-termism” in their publicly held investee companies? • Can institutional investors become more effective “stewards” of publicly held investee corporations? This significant paper serves very important purposes: 1. It demonstrates that addressing these three generic questions is critical to individuals, equity markets, publicly held companies, the economy—and to the troubling (and conceptually difficult) issue of good v. bad short-termism in investor and investee behavior. Institutional Investors 1 2. But, as the paper also demonstrates, there is, indeed, a lack of information and analysis on a host of important empirical and prescriptive issues that relate to these three critical questions. 3. The paper persuasively makes the case that we need to have as much under- standing about investor entities as we do about investee companies. 4. It points the way analytically towards the variety of issues which need to be addressed in answering the three generic questions—without trying to bias the outcomes. It invites much greater attention to these critical questions from all across the intellectual and policy spectrum and urges think-tanks and academic institutions to develop comprehensive programs to address the profound implications of the changing world of institutional investors. 5. We believe that the paper is an important contribution to the public debate because rather than arguing for new regimes of public policy or private ordering without facts, it proceeds from the proper belief that factual and policy analysis are inextricably bound together. In the end, the paper poses the essential question: are shareholders part of the problem with modern capitalism or part of the solution? The answer, invariably, will be complex and nuanced, without a simple, single conclusion. But, in so effec- tively laying out the need for an informational foundation, this essay takes a vital step towards finding answers, either through public policy or private ordering. The Millstein Center for Corporate Governance and Performance and the Com- mittee for Economic Development are pleased to publish this working paper. We thank Stephen Davis and Ben W. Heineman, Jr. for both their intellectual leadership on this topic and their authorship of this paper. We also thank the participants of the roundtable and the many reviewers who provided helpful comments during the drafting of this paper. Thanks are also due to CED’s Corporate Governance Subcommittee, which helped to develop the topic in an early phase and later reviewed the paper at its conclusion. Responsibility for the content lies solely with the authors and does not necessarily reflect the views of the institutions with which they are affiliated or the views of individuals who participated in the roundtable and subsequent reviews. Ira Millstein Roger W. Ferguson Senior Associate Dean for Donald K. Peterson Corporate Governance Co-Chairs Yale School of Management Committee for Economic Development New Haven, CT Washington, D.C. October 2011 2 Institutional Investors Are Institutional Investors Part of the Problem or Part of the Solution? Key Descriptive and Prescriptive Questions About Shareholders’ Role in U.S. Public Equity Markets By Ben W. Heineman, Jr. and Stephen Davis October 2011 Institutional Investors 3 Over the last twenty years, institutional investors have owned an increasing share of public equity markets—more than 70 percent of the largest 1,000 companies in the United States in 2009, for example.1 Over the past two years, in response to failures of some boards of directors and business leaders, shareholders, including institutional investors, have been given increased powers to participate in—or have disclosures about—discrete spheres of governance in publicly held corporations.2 Moreover, during this same period, and in multiple jurisdictions, there have been increasing calls from both the public and private sectors for institutional investors to play a broad “stewardship” role by “engaging” with investee companies to “help achieve long-term sustainable value” and to help curb excessive risk taking seen as a factor in the financial crisis.3 But with these shifts in market and legal powers have come questions about institutional investors which are similar to those raised in the recent past about the corporations in which they invest. These questions relate to goals, strategies, governance, performance and accountability and, importantly, the separation of ownership and control (agency problems).4 They boil down to a bedrock query: do investors have the capacity to perform the role now expected of them? Institutional investors in this paper include: pension funds, mutual funds, insurance companies, hedge funds and endowments of non-profit entities like universities and foundations. Policymakers who championed the transfer of enhanced powers to investors went well beyond available knowledge in crafting such a response to the financial crisis. This is perhaps understandable in light of the severity of the 2008 market seizures and the political pressures that arose in their wake. But there is no mistaking that the approach represents, in effect, a big bet that investor institutions can and will exercise rights responsibly, and that such behavior will make markets more sustainable, less prone to error, and more in sync with the interests of capital providers. Moves to further empower investors lend urgency to the need to deepen knowledge of investor behavior. Three leading US bodies—the Aspen Institute Business and Society Program, the Committee for Economic Development and The Millstein Center for Corporate Governance and Performance at the Yale School of Man- agement—agreed to explore this issue, especially because the level of available research effort and prescriptive analysis lags behind the voluminous writing on publicly held corporations. The trio convened a research roundtable in January, 2011 with academics, think-tank analysts, leading practitioners and former regulators. The purpose was to identify salient areas for future research and analysis. The research roundtable focused on three fundamental and potentially interrelat- ed issues about the role of institutional investors, all of which require more empirical and normative analysis. First, do such investors adequately advance the goals of the individuals who give institutions their money—whether those individuals are pension fund beneficiaries, mutual fund investors, insurance beneficiaries or hedge fund investors? The basic 4 Institutional Investors question is the classic “principal/agent” problem: do those who manage the trillions of dollars of other people’s money advance the interests of the ultimate beneficiaries—who may be dispersed and disengaged—or their own interests? This question has special salience today because of the many different steps in the investment chain. Agents abound. For example, one common sequence is that an individual contributes money to a pension fund; the trustees and executives, after being advised by an investment consultant, then allocate those monies to both internal and external fund managers, or to managers of fund of funds who in turn distribute the monies to yet other asset managers.5 Second, do institutional investors contribute significantly to

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